Back in March we wrote about Iceland’s response to the banking crisis, and how it differed to other countries that stepped in to support their banking systems. This week, Paul Krugman commented about Iceland’s exit from its IMF programme. The IMF has declared that programme successful, and Krugman claims that Iceland is back in the capital markets and has its “society intact”. He puts this success down to three things – debt repudiation (default), capital controls and currency depreciation. In fact the opposite of the approach that the distressed Eurozone economies are forced to endure.

Krugman acknowledges that Iceland has a way to go – unemployment is nearer 7% than the 1% it stood at before the crisis. But is default a better option than austerity and an overly hard currency?

Well we have a control of sorts for this experiment. Another member of Alex Salmond’s Arc of Prosperity, Ireland is taking the other path. Having borrowed EUR 67.5 billion from the EU and the IMF in 2010, Ireland committed to an aggressive austerity package, and far from defaulting, the government explicitly guaranteed the debts of its broken banking system. The 4 year austerity plan raised sales tax, cut government spending and reduced the minimum wage, with a plan to get the deficit below 3% of GDP by 2014. Is that working?

Well we’ve just seen quarterly GDP growth of 1.9%, the highest rate since the end of 2007 (most quarters since then have been negative), although unemployment remains around the 14% level, and I guess the best you could say is that it’s no longer rising. Stronger exports have helped – domestic weakness persists. One measure that has improved dramatically as the result of the austerity programme has been Ireland’s borrowing costs. Since mid July, the longest dated Irish government bond has fallen in yield from 12.5% to under 8.5%, making this one of the best performing bond markets in the world – and in sharp contrast to Spanish and Italian bonds over that period.

It will be interesting to see which approach to national indebtedness proves most successful over the longer term – I’ve always said that I thought that an early default against bondholders by the peripheral Europeans was the best outcome for those populations. It’s almost certainly what the populations would vote for, if, like the Icelandics, they were offered the choice. Credit rating versus a job for your kids? No contest. As George Osborne follows the austerity path for the UK in defence of its AAA rating (now lost by the US, which then saw one of biggest ever monthly rallies in its bonds), we’re also part of these experiments.

Finally a reminder about our new Twitter feed, @bondvigilantes. We’ve been going for a couple of weeks now, and as well as linking to this blog, we’ve tweeted our views throughout the day of the US AAA downgrade, and on our not very widely held assertion that Alistair Darling had a “good” credit crisis. We also tweeted a link to the new and utterly crucial remastered and complete Smiths box set. Join us, join us.

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Yohaysays:

Great comparison! Here in Spain, the people of Iceland are heroes. In the tent camps that were here a few months ago, there was an area designated to Iceland.
In many things, Ireland and Spain are similar: housing boom and bust, relatively balanced central governments, problematic banks and dependence on the ECB. I wonder how the Irish austerity will mean for Spain.

My worry is that people think there is a recipe solution which can be followed to solve the problem. Undoubtably in my view Iceland did the right thing, but apart from banking there was not much structurally wrong with Iceland. It probably is a recipe that Ireland should have followed, but Ireland fundamentally has a few more issues, namely in my opinion tax rates and their public sector. Greece should have followed the same route but here there are even more structural problems.

Its not a plain choice between austerity and default, it should be seperate discussions. Whether to default should be determined on whether your economy can grow with the debt levels it has. The other choices are whether you fix the structural problems and whether you apply short term stimulus. The judgement should be about whether the balance of all 3 is correct. That most governments are making a hash of things by half heartedly tackling structural problems and not applying stimulus or really tackling debt is perhaps a different discussion.

As for protest songs then I think they are still out there. The King Blues could put even Billy Bragg to shame. That these are not so prominent is a reflection on a more fragmented youth culture and a mature music industry. Can you really judge whether rebellion by singing protest songs, or rebellion by breaking societies rules by being selfish and expecting the easy root to fame and fortune is correct. Perhaps the problem is that there is so many things to tackle now, with so many differing voices that no single voice comes to the forefront. What I do know, is the simmering anger is still there underneath on a whole swathe of issues across different age groups, unlike anthing I have seen before.

This is a fascinating comparison. The big difference here I guess is the impact of defaults. Iceland was relatively small and unimportant so its default didn’t cause too much pain.

The problem with an Irish default if it happened, is the impact on the balance sheets of European banks. The market would behave as if the other struggling countries such as Spain had defaulted, leading to a serious European banking crisis with no one wanting to lend to them.

Liquidity would freeze and we would probably be back to a Lehman like crisis with confidence plummeting etc…

But I tend to agree that a default / restructuring would be the way to go for the worse cases, then these countries could recover more quickly, lenders would know they could service their debts once more, interest rates would come down – but you would have to somehow credibly insulate the banks or we’ll be looking at a severe recession across Europe driven by a new liquidity crisis.

I will always be by the side of people who pay their own debts.
It’s very easy and very coward to solve the problem with a default.
This rule is the basis of human respect.
Honor to Irland and shame to Iceland and to those who believe this is the best outcome.

Michele, I agree … you should pay your debts and if you cant pay them you are forced into bankruptcy. This is what should have happened in the case of the Irish banks. They took the risks, they got the gains (for a while at least). It was nothing to do with the Irish people. I wish Ireland had been as strong as Iceland, they did the right thing … refused to accept that private banking debt = sovereign national debt.

the icelandic economy is growing, and so is employment. but many assets have been wiped out? how much has the icelandic worker paid in terms of destroyed assets for the default?
also, the currency is way down: the now happily employed-again icelander is making what % of his former salary in real terms? how much of the real value of his bank savings has been wiped out?

I think the author approaches this from a very balanced perspective, which is a relief in this day and age.

However, there is one huge difference between Ireland and Iceland that was not really mentioned. Iceland has its own currency and Ireland is simultaneously restricted (in currency terms) and supported (in trade and fiscal terms) by the Eurozone.

This is also partly the reason why “michele” is so badly wrong about there being absolutes for states like “It’s very easy and very coward to solve the problem with a default.”. The only thing that is easy is that statement as an individual. Also, can an Icelander eat your “respect” or cover their freezing skin with it?

Regardless of who is to blame, the long term costs, benefits and other consequences for defaulting are the only considerations that matter. If you are still in control of your own currency and are preferably a miniscule part of the global economy, it may make perfect long term sense to default!

In addition, you could argue that sovereign default is like bankruptcy or insolvency. Capitalism simply does not work if one of the possible outcomes is not permitted. It is simultaneously the strongest discipline (look at how many hedge funds failed during the financial crisis and WILL fail in future) and correct outcome mathematically and economically for failure with capital and risk.

There is also the strong argument of moral hazard. After all, if you are insolvent, who is going to pay for you? What happens if you need money again? Etc.

Default, like bankcruptcy, is a necessary component of capitalism. This is has been forgotten time and time again now and in the past at everyone’s continued peril.

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